Minsky Having a Moment?
The Wall Street Journal recently featured a lead article on economist Hyman Minsky: In Time of Tumult, Obscure Economist Gains Currency.
Minsky is increasingly cited by leading financial figures such as PimCo bond fund manager Paul McCulley and Prudent Bear's Dave Noland. According to the WSJ article, the Levy Economics Institute of Bard College plans to reprint his major works. The recent sub-prime crisis is described by some as the markets "having a Minsky moment".
Minsky's central idea is the Financial Instability Hypothesis, which holds that the periodic crises that afflict "capitalist" economies are endogenous to the capitalistic financial system, that once a crisis has started the natural tendency of the system is toward amplification rather than equlibrium, and that "stability breeds instability". From Minsky's paper, "over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."
In short, during periods of stability, the perception of risk among financial players is diminished, leading to more risk taking. The risky structures that are established during a period of stability eventually start to topple, leading to a self-feeding process in which they bring each other down:
- In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
Minsky has in common with the Austrian school that monetary phenomenon are responsible for the cyclical behavior of modern financial economies, in particular the banking system, inthat he finds the strict quantity theory of money insufficient to explain inflationary processes:
- In contrast to the orthodox Quantity Theory of money, the financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers (using the term generically for all intermediaries in finance), whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market. This innovative characteristic of banking and finance invalidates the fundamental presupposition of the orthodox Quantity Theory of money to the effect that there is an unchanging "money" item whose velocity of circulation is sufficiently close to being constant: hence, changes in this money's supply have a linear proportional relation to a well defined price level.
After reading the paper posted to the Levy site, it seems to me that the existence of fractional reserve banking and central banking is essential to his hypothesis. Indeed, the above quote is a pretty good description of how fractional reserve banking works.
Suppose we start out from a period of "stability" or "equilibrium". The perception of risk is low, so financial market players start creating more securities. In a system of on 100% reserve banking, the interest rate is a price that balances present savings against the demand for future goods. In the absence of a mechanism for creating more claims to assets unbacked by any real assets, and without more actual savings being drawn into the market to fund the assets, the price of these assets would fall fairly quickly, limiting further investment. The decline in asset prices represents the increasing cost of fund future consumption out of the finite pool of present savings.
This is known in Austrian theory as "the interest rate brake". But a central bank can fix the rate of interest and create out of nothing unlimited quantities of debt without the interest rate moving. The cycle plays out according to the Austrian school as the perception of savings is greater than the reality, enabling more investment to be undertaken than can be funded out of actual savings.
While the Great Austrian Critique of Minsky has yet to be written, the critique will focus on a difference over the nature of economic-financial crises in a capitalistic economy: endogenous (Minsky) or exogenous (Austrians)? Are fractional reserve banking and central banking inherent to a market economy, or are they a destructive form of central planning?
Comments (8)
John
If the existence of a central bank is fundamental to his analysis (and fractional reserve banking), then really whether it is endogenous or exogenous really doesn't appear to be a big difference. If an Austrian said that fractional reserve banking is inherent to the capitalist system, then the Austrians theory would be endogenous as well. Minsky doesn't attempt to explain what a capitalist system should be the way Austrians do. Therefore, I'm willing to accept the Austrian definition as it is much more completely developed and the exogenous nature of financial crises.
Published: September 9, 2007 1:09 PM
Fundamentalist
"...he finds the strict quantity theory of money insufficient to explain inflationary processes..."
I don't understand. How does Austrian econ differ from the "orthodox Quantity Theory of Money"?
Published: September 9, 2007 3:09 PM
Anthony
John makes a good point. Does Minsky even question the premise that the central bank is a sine qua non of capitalism?
Published: September 9, 2007 3:31 PM
Robert Blumen
Question: "How does Austrian econ differ from the "orthodox Quantity Theory of Money"?"
The strict quantity theory posits a linear relationship between the quantity of money and all prices in the economy. Increase the money supply by 10% and you get 10% inflation in all prices. Relative prices to not change.
The Austrian view emphasizes that a change in the quantity of money changes not only the level of all prices, but relative prices as well. The new money is created at a particular point in the economy, and it spreads out from there. Those who receive it first are able to spend it on some goods, whose prices will rise; then the second-round recipients are able to spend it, and so forth.
This idea is central to Mises theory of the business cycle. Mises pointed out that when money is created through bank credit, that the interest rate is affected (lowered) because credit no longer depends on the availability of savings, so more of it can be created, and therefore at a lower price.
Published: September 9, 2007 6:52 PM
Daniel
Straw man definition of capitalism. Not much to see here.
Published: September 9, 2007 9:48 PM
Fundamentalist
Thanks for the clarification, Mr. Blumen. I should have known that. Monetarists have always held that an increase in the money supply affects everyone equally and affects only prices, while in reality it disrupts the production structure.
Published: September 10, 2007 7:54 AM
Allen Dalton
To be fair to Monetarism - No Monetarist that I know of has ever said that (1) an increase in the money supply affects everyone equally, or (2)that relative prices do not change when the money supply changes. Rather they argue that relative price changes are secondary or tertiary in importance to the effect of changes in nominal income. They may be wrong on this score, but let's accurately portray their arguments.
Published: September 10, 2007 10:53 AM
Stephane
I have almost finished Minsky's opus "Stabilizing an unstable economy". It is striking how much his observations about monetary instability resemble the Austrians', and how much his conclusions differ.
He focuses more on private banking as the source of instability, rather than on central banking. But this endogenous vs. exogenous difference between Minsky and the Austrians shouldn't be overrated, because there is also an endogenous part in Austrian monetary theory. Minsky distinguishes between commodity pricing and asset pricing, as well as between labor wages on the commodity and asset markets. This looks like a hayekian triangle, or what? Of course, there is a lot of keynesian blah blah about prices driving wages driving prices, thus triggering inflation, etc.
The most curious is that he considers that an unstable banking system is a normal feature - and, it seems, almost a necessary feature - of a dynamic capitalist economy. The 'necessary' part, however, is given without any argument as far as I can see. He also takes note that we now live in a Big Government environment, and describes some of the consequences. This begs the question : shouldn't such dysfunctional institutions (fractional reserve banking, central banking, Big Government) be changed? But Minsky doesn't seem to ask this kind of question.
Minsky was not quoted in Pr Garrison's Time and Money. Well... it would be great to have his Austrian critique of Minsky!
Factoid : when I tried to purchase Minsky's book on Amazon a few months ago, it was out-of-print and prices for old copies were skyrocketing (between $1000 and $3000!!!). These prices then started to fall slowly when a reprint was announced for May, but they are still above $500. Scarcity and fetishism, no doubt...
Published: May 20, 2008 12:06 PM